The Stochastic oscillator is designed to oscillate between 0 and 100. Low levels mark
oversold markets, and high levels mark overbought markets. Overbought means too
high, ready to turn down. Oversold means too low, ready to turn up.
Look for buying opportunities when the Stochastic oscillator nears its lower reference
line. Look for selling opportunities when the Stochastic oscillator nears its upper
reference line. Buying when the Stochastic oscillator is low is emotionally hard
because markets usually look terrible near bottoms, which is precisely the right time
to buy. When the Stochastic indicator rallies to its upper reference line, it tells you to
start looking for selling opportunities. This also goes against the grain emotionally.
When the Stochastic indicator rallies to a top, the market often looks fantastic, which
is a good time to sell.
Newbie traders use indicators by themselves. Don't do this. Use the Stochastic
indicator with other technical indicators. Keep in mind that when a powerful uptrend
begins, the Stochastic indicator quickly becomes overbought and begins showing
premature sell signals. In a sudden panic sell off, the Stochastic indicator quickly
becomes oversold and begins showing premature buy signals. Therefore, this
indicator only works if you use it with other trend-following indicators.
Should you wait for the Stochastic indicator to turn up before buying? Should you
wait for it to turn down before selling? No. If you wait until the Stochastic turns,
you'll miss out on making a lot of money. What you are trying to do is enter as soon as
the Stochastic indicator reaches an extreme. View very low or very high Stochastic
readings as a measure of the emotion in the crowd that is trading your stock. The
more the emotion, the better. It is easier to make money from emotional traders than it
is from calm, rational traders.
If you see a positive divergence between the Stochastic and the price of a stock, go
long. A positive divergence is when the stock price drops to a new low, but the
Stochastic indicator makes only a slight low and does not break to a new low. Do the
opposite on the downside. If you see a negative divergence between the Stochastic
and the price of a stock, go short. A negative divergence is when prices rise to a new
high, but the indicator goes down or barely rises at all.
You should not buy a stock when the Stochastic is high. Conversely, you should not
sell a stock when the Stochastic is low. This is probably the most accurate way to use
the Stochastics. Reverse your thinking and look at it as telling you when NOT to trade
a stock. Indeed, moving averages are superior to the Stochastic at picking up on trends,
the ADX is better at catching entry and exit points, but the Stochastic is the best at
telling you when you should NOT trade a stock.